Have you heard of CFD trading? Do you want to know what it is? Here we’ll be discuss all about CFD trading, its meaning and how it works along with other crucial details.
CFDs are popular instruments which are common between many professional traders’ portfolios as they can access assets at a much lower cost than what they will incur if they actually buy them outright.
Now lets understand what CFDs are, how they are traded and advantages of CFDs so that you can understand whether they are the right instrument for you or not?
What is CFD? Full Form
CFD stands for “Contract for Differences” which means that it is a contract between an investor/trader (buyer) and a CFD broker (seller) to exchange the difference between the contract open time value and the contract close time value of any financial product.
CFD Trading: Meaning
Basically the traders speculate on the price of an asset (shares, indices, commodities, currencies, and treasuries) depending on the market conditions and agree to exchange the difference in the price of an asset without taking the ownership of underlying assets. As they derive their value from the movement of an underlying asset, CFDs are a form of derivative trading.
Whether you will make profit or incur loss depends on how accurate your prediction is for the future price of an asset. Therefore, you can speculate on price movement in either direction and earn a profit provided your prediction is correct. Technically speaking, you can take both long and short positions.
CFD Trading: How does it Work?
As you know that the seller and buyer participate in a transaction based on the price movement of the asset, so if the price of the asset increases during the course of the CFD, the seller pays the difference in price to the buyer.
On the other hand, if the price of the asset is lower when the trade is closed, the buyer pays the difference in price to the seller. Thus, only the monetary change in the value of an asset is transferred between the buyer and the seller but not the asset itself.
CFD Trading Process: Steps to Follow
Trading CFDs are definitely different from trading shares but it is a simple process. To classify, there are 4 major steps you need to follow to execute a CFD trade:
1. Choose Your Instrument
The first step is very obvious that you have to choose which assets you want to choose for trading as CFDs. It can be share CFDs, index CFDs, cryptocurrency CFDs or commodity CFDs. You can choose the type of asset with which you are most comfortable or you can also go with the markets which are trending and hitting the headlines that time.
While choosing the instrument, you should dig all specifications at your broker’s specific CFD page so that you get the important details like leverage, margins, and trading costs.
2. Choose Your Position:
Once you decide the kind of CFD you want to trade, then you need to decide on your position whether to open a long position (buy) or whether to open a short position (sell). This decision depends on your analysis whether you think that the price of the asset will increase or decrease in the near future.
You should use logical decisions with the help of charts, indicators, signals and research reports.
3. Choose the Size of the Position:
After you choose the position of your trade, you must also simultaneously decide the size of your trade. The value of one unit of CFD depends upon the type of instrument, therefore you must calculate and compare the number of units that works best and fits your trading strategy.
4. Choose Your Trading Platform:
Trading platforms should also be chosen carefully as they differ in terms of margins, leverage and trading costs. Also the tools, indicators and charts have different utilities depending on the platform you choose.
Today, MT4 and MT5 are popular in the industry for CFD trading as they provide you with more than 50 technical indicators and charting tools.
Also, you can trade on mobile apps and keep track of profits/losses on-the-go in real-time.
CFD Trading Example
Suppose you predict that the price of shares of ABC Ltd will go up so you take a long position and buy 1,000 CFDs at $10 price. Let’s assume the broker’s commission is .10% of trade size, so the commission will be $10 (1,000 units x $10 = $10,000 x 0.10%).
If your prediction goes right and the price went to $11 and you want to close your buy trade. A commission will be charged again i.e. $11 (1000 units x $11 = $11,000 x 0.10%).
Then your profit will be calculated by difference in the trade size minus all the commissions and fees of the broker. Therefore, in this case your profit will be $979 [($11,000 – $10,000) – (10+11)].
In the above if the margin rate of your broker is 3%, you can earn $979 by investing $300 (3% of 10,000).
However, your prediction can go wrong which can result in losses as well. So, you must be aware of the high volatility in CFD trades.
Advantages of CFD Trading
- Big potential profits: As CFDs are leveraged products, you as a trader can make greater profits with very small investments than you normally could have with the trading of shares. But at the same time there is a huge risk of you losing your wealth.
- Protection against loss: If you think that the price of the stocks that you own are going to fall in the near future, you can offset your losses to the value of the portfolio through CFDs instead of selling the shares.
- Commodities: CFDs are also used to speculate on the price movements of commodity markets such as oil, gold and silver.
- Broad market access: You can speculate on thousands of financial products and global markets through CFDs which you may not be able to access otherwise.
- Profit from losses: By taking any position (long or short), you can earn profit from both the rising and falling price of any stock or commodity.
- No expiry: CFD don’t have a set expiry date unlike many other types of derivative, that means traders can end the contract to realise a profit/loss whenever they decide.
CFD Trading: The Bottom Line
There are many advantages of trading CFDs like lower margin requirement, access to global markets easily, and lower fees.
However, with large profit opportunities comes larger risks as high leverage can maximize your losses in the same proportion. So, the spread looks very attractive to enter a market but at the same time, it is very risky. Plan your strategy wisely and with extreme caution. Be wary of the associated risks and move in the right direction.